Capital Requirements for Banks and Their Impact on IT Strategy

Many banks probably haven’t taken a close look at the repercussions on IT.

Sinan Baskan, Vice President, Capital Markets, SAP

By now, financial institutions are getting acclimated with new requirements on capital reserves from central banks. One focus of scrutiny is how these regulations will impact their IT strategy.

First, some background. In July 2013 the Federal Reserve Board finalized a package of regulatory reforms to help ensure US banks maintain strong capital positions. The intention is to enable banks to continue lending to creditworthy businesses and individuals following unforeseen losses or severe economic downturns. The new regulations grew out of rules established by Basel III, as well as the Dodd-Frank Wall Street Reform and Consumer Protection Act. The US Treasury Department has deferred to, and Congress has authorized, the Federal Reserve to enforce Basel III at its own discretion.

Without going into all the details, banks will have to maintain a minimum ratio of common equity tier-1 capital to risk-weighted assets of 4.5 percent, and a common equity tier-1 capital conservation buffer of 2.5 percent of risk-weighted assets. The rule also raises the minimum ratio of tier-1 capital to risk-weighted assets from 4 percent to 6 percent, and includes a minimum leverage ratio of 4 percent. Large banks had to begin phased-in compliance in January, while small banks have another year before their phase-in period begins.

The new rule will have a significant impact on banks’ balance sheets. It will also have a profound effect on their IT strategy going forward. Many banks probably haven’t yet taken a close look at the repercussions on IT.

Simple Math

The math is pretty simple: Any bank that needs to increase its proportion of reserve capital will then have less cash and working capital. That means it will have to make a reduction from capital investments and operational expenses. The question is, what’s the appropriate mix?

There are potential advantages to each choice, depending on the bank’s unique situation. For example, the bank might get tax relief for certain types of capital investment. There has always been a clear practice to determine the tradeoff between capital expenditures and operating expenditures based on the capital structure and cost of capital. Reducing fixed costs or transforming them into variable cost has been a common practice. Increasing capital reserves will change the metrics of these calculations, and the details will determine the implication for IT.

For instance, which assets will be counted toward reserves? Would sovereign-debt portfolios qualify? Which valuation methodology is acceptable?

The cost of capital applied would vary for the tiers and in the capitalization structure, as a different risk profile would apply. In short, each bank will have to go through the exercise of determining the right balance that will maximize its return on equity.

The Perfect Balance

Ultimately, the impact on IT will be an acceleration of recognized trends. One is a shift to cloud computing—that is, migrating high-fixed-cost operations to more variable-cost models. Another is adopting new funding models, such as multiyear budgets, in some instances. The upsides of cloud computing include lower upfront costs, more predictable ongoing costs, and the ability to quickly ramp up or down as required.

Alternatively, investments in energy-saving measures; new applications or platform upgrades for competitive positioning; or new hardware, software, or other technologies that quality for tax incentives may lead to consolidation or migration of on-premise IT assets to brand new facilities.

The choices for funding and deployment models aren’t necessarily new, but the timing and the calculus of determining the near- and long-term mix has now changed. Deciding which aspects of IT to retain in-house and which to offload through cloud computing or outsourcing is far from a simple exercise. But one thing is certain: new rules for capital-reserve requirements will have a profound, long-term impact on banks’ IT strategy.

Sinan Baskan is Vice President, Capital Markets for SAP. He is responsible for developing integrated solutions for Capital Markets and Business and Ecosystem Development. His team has developed and delivered solutions for e-Trading, Risk Analytics and Regulatory Reporting and Compliance for financial services customers. Prior to his current position, Sinan was Vice President of Risk Technology for the Americas at HSBC Corporate and Investment Bank. He has held positions in engineering and product management at Sybase (1993- 2005) and rejoined Sybase in 2007. He started his career at Philips Research Laboratories and at IBM Research Division.

I think most firms have already started down this path, driven by not just capital requirements but overall lower margins in financial services and the impact of the financial crisis. Another factor is the required spending for regulatory compliance in general - the net impact is the same regardless of source, less discretionary spending on IT and a strong incentive toward vendor-provided solutions for commodity services.